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Despite First Signs of Easing Inflation, Spiking Food/Energy Prices May Cause Recession

We live in a highly interconnected world, not only via internet, but economically.  The Russian aggression and subsequent sanctions are going to have worldwide economic consequences, none of them positive.  Add to that the already weakening U.S. economy and a Fed just beginning its tightening cycle, and you have the makings of recession.

Employment – Labor Market Is Loosening

The employment data for February came in better than expected with the Payroll (Establishment) Survey bouncing +678 (consensus estimate: +423K).  The Household Survey rose a similar +548K.  The headline Unemployment Rate (U3) fell to 3.8% from 4.0%, but the broader (U6) measure, which includes those working part-time, wanting full-time but unable to find it, and most likely a better indicator of labor market conditions, rose slightly to 7.2% from 7.1%.  That indicates that the labor market isn’t as “tight” as the U3 rate would imply.

Corroborating that view was the rise in the Labor Force Participation Rate (LFPR), something we’ve forecast for the past few months. (The LFPR is the percentage of working age population either with a job or looking for one.)   It rose to 62.3% in February, closing in on the 63.4% pre-pandemic level.  This gauge was as low as 60.2% in April 2020.)  The “fee money” federal programs were mostly responsible for the slow return of the LFPR to its pre-pandemic levels.  In Canada, for example, the LFPR returned to its pre-pandemic level in the spring of 2021.  Now that those federal programs are in the rear-view mirror, labor force re-entry is occurring.  For example, the LFPR for those without a high school diploma jumped 2.3 pct. points from 44.5% in January to 46.8% in February.  That’s huge!!  And for men aged 55+, it rose to 45.3% from 45.0% in January and 44.2% in December.

The return of the population to the workforce had an immediate impact on wages which, through January, were rising at a 5.5% annual rate.  But, in February, average wages were flat (0.0%) with two-thirds of the sectors posting declines (the median was -0.1%).  That lowered the annual rate to 5.1%.  And, while the workweek did rise 0.3% with work based pay rising a similar amount (since wages didn’t rise), inflation is sure to have eaten into real purchasing power.  The expectation for CPI is for a +0.8% rise, and that’s before the spike in food/energy caused by the Ukrainian invasion.  That will make five months in a row of contraction in real average weekly earnings – not a good omen for economic growth.

Geopolitical Impacts of Russia’s Invasion

  • Because Russia and Ukraine are significant providers of natural resources (oil, natural gas, aluminum, tin, nickel, coal, wheat, corn…) the prices of commodities will continue to rise.
  • China is observing what impacts the sanctions are having on Russia.  If it has any ambitions regarding Taiwan, it will have to insulate itself from such sanctions.  To do that, it will have to continue to stockpile its reserve of commodities, adding additional upward price pressures. We may just be at the beginning of yet another commodity price cycle, this one a supercycle!  The right-hand side of the chart shows that commodity prices were rolling over and heading down prior to Russia’s invasion.  That has all changed!


With crude oil now at $115/bbl., and commodity and food prices also grinding higher, inflation will likely remain elevated.  The SF Fed has estimated that the Y/Y changes in Covid-sensitive sectors has been +6.7% Y/Y (February data), while Covid-insensitive sectors rose a more moderate +3.6%.  The chart below is the Goldman Sachs (GS) estimate of inflation from these Covid-sensitive sectors (the ones that had significant supply issues).  For example, the computer chip shortage impacted the prices of new, used and rental cars, and shipping (port) issues impacted furniture and appliance prices.   As seen from the GS forecast, the peak in these Covid-sensitive sectors was forecast for Q1/22 with a significant fall thereafter and to such an extent that deflation in these sectors was forecast for 2023!   

Most of this is still likely.  The problem is that the rising price of gasoline for those new and used cars will offset the (forecast) fall in auto prices.  Thus, driving will continue to be expensive and an anchor on economic growth.

A Slowing Economy

As we have documented in our past blogs, economic growth has been slowing.  The Atlanta Fed’s GDPNow forecast model has Q1 GDP growth at 0%, and the St. Louis Fed forecast is not far behind. 

U.S. consumer spending in real (inflation adjusted) terms has been flat since October.  Buying intentions from the University of Michigan surveys are at or below recessionary levels for vehicles, major appliances, and homes (see the following three charts), and overall sentiment (pre-invasion) was nearing ’08-’09 recessionary levels (see chart at top). No doubt March’s University of Michigan Survey will show further deterioration, as the surge in food and energy costs acts like a regressive tax, impacting lower income earners hardest.

Enter the Fed

We have some members of the Fed’s Federal Open Market Committee (FOMC) clamoring for an aggressive policy of interest rate hikes (specifically, a rise of 1 pct. point in the Fed Funds rate by mid-year), as if the Fed can do anything about commodity prices.  Note that higher interest rates, like food and fuel prices, impact lower income earners more than higher earners via higher credit and mortgage costs.  Thankfully, Fed Chair Powell (now pro-temp as his term as Chair ended in February and the Senate has yet to confirm him for another term) indicated at his recent Senate hearings (March 1,2) that policy tightening wasn’t pre-set and would be “data dependent.”  Thus, as the slowdown unfolds, expect the Fed to be less aggressive.

It appears to us that most of the Fed’s rhetoric around raising interest rates is politically induced.  There certainly is pressure from the White House where the President’s approval rating is in the dumpster.  But, there really is nothing the Fed can do about supply induced price increases.  It’s tools lower demand, but as discussed, lower demand is already becoming an issue.

The chart shows where interest rates are in this cycle relative to where they “normally” are when a Fed tightening begins.  The difference between the 10-Year Treasury yield and the 2-Year Treasury yield (called the 10-2 spread) is currently 25 basis points (down 10 basis points in just the last two days (March 3,4)).  The 10Yr.= 1.74%; 2Yr.= 1.49% as of March 4.  Remember, history tells us that a recession has occurred 100% of the time when the yield curve “inverts” (short-term rates higher than long-term).  On the chart, the dashed vertical lines show the 10-2 spread when the Fed began to tighten in past cycles.  Note that the Fed “normally” begins tightening with the 10-2 spread at 150 basis points, and that the negative spreads in 1990, 2000, 2006, and 2020 all presaged recessions.   Playing with fire here!

Other Data

  • Pending Home Sales fell -5.7% M/M in January and mortgage applications continue to fall (-0.7% W/W February 25; -13.2% W/W February 18 and -41.7% Y/Y).  Could it be sky high home prices and rising mortgage rates?
  • The Fed has indicated that when it begins QT (Quantitative Tightening – selling down its balance sheet), the sale of a significant level of mortgage-backed securities would be a priority.  This will only add upward pressure to mortgage interest rates.
  • While the ISM Manufacturing Index for February (58.6) was up (57.6 in January), the ISM Services Index bombed (56.5 in February vs. 59.9 in January with the consensus estimate at 61.1 and a 68.4 peak last November).  The all-important Business Activity sub-index fell to 55.1 from 59.9 (was 72.5 in November).  New Orders came in at 56.1, down from 61.7.  And, corroborating our view that the employment situation is easing, the Employment sub-index fell into contraction territory at 48.5 in February vs. 52.3 in January (50 is the demarcation between expansion and contraction).
  • Real Disposable Personal income (DPI) fell -0.5% M/M in February, and is now down six months in a row.  Since 1960, such a string of negatives has only occurred once outside of recession.  The consumer has been using savings to support retail sales, but those “savings” were built-up from the free “helicopter” money, and that has now been spent.  The savings rate, at 6.4% in February is now below its pre-pandemic level and the lowest it has been since December 2013.  As a result, savings are unlikely to be a support for retail sales going forward.

Final Thoughts

The Employment Report looked robust only because the long-predicted return of former employees to the workforce occurred in earnest in February.  The end result was the first sign of an easing in wage pressures.  It also appears that supply related issues are easing and inflation from this source is expected to steadily fall over the next couple of quarters and then actually turn negative in 2023.  Unfortunately for the working class, Russian aggression has significantly lifted food and energy prices.  The economy was already slowing with consumer surveys showing recessionary readings.  The spike in food and fuel prices will only make it worse, with a high likelihood of tipping the economy into recession.

The Fed is embarking on its tightening path late in the cycle mainly spurred by the political need to “do something” about inflation.  Fortunately, in his testimony to the Senate last week (March 1,2), Chair (pro-temp) Powell did reiterate that the Fed would be “data dependent” going forward.  Thus, with the first sign of an easing in inflation (0% wage growth in February), interest rates fell across the curve after the Employment Report (Friday, March 4), as markets priced in fewer Fed rate hikes.  Given our view of a weakening economy, we still believe that there will be a lower number of hikes than are even now priced in – i.e., we would take the “under” in an over/under wager.

Robert Barone, Ph.D.

(Joshua Barone contributed to this blog)


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